I am a senior editor at Forbes, covering legal affairs, corporate finance, macroeconomics and the occasional sailing story. I was the Southwest Bureau manager for Forbes in Houston from 1999 to 2003, when I returned home to Connecticut for a Knight fellowship at Yale Law School. Before that I worked for Bloomberg Business News in Houston and the late, great Dallas Times Herald and Houston Post. While I am a Chartered Financial Analyst and have a year of law school under my belt, most of what I know about financial journalism, I learned in Texas.

Don't Blame High-Frequency Traders For The Mistakes Of Dumb Traders

High frequency traders got a bum rap in Michael Lewis’s bestselling “Flash Boys,” which in turn inspired class-action lawsuits like this one from the Wall Street watchdogs at Robbins Geller.

Like a lot of people, I was puzzled when I read the premise behind Lewis’s book, not to mention the follow-on litigation. It seemed he was describing a market maker who was disappointed that he couldn’t earn as much money as he used to flipping stocks because HF traders were cutting down the spread. That’s a good thing for most investors, even if it’s painful for people who used to make a living buying low and selling high.

An article in the current issue of the Financial Analysts Journal makes a similar point. While there are abuses and illegal practices among the high frequency crowd, the advent of millisecond buying and selling by armies of computers has narrowed spreads, increased liquidity and made things better for small investors.

HF’s main victims have been big, low-frequency traders, who need to realize that computers are now watching the markets like hawks circling over a freshly mowed field, ready to swoop in on any sign a human trader is trying to move into or out of a big position.

“The low frequency traders have to understand the way you trade in high frequency markets is not the way you traded in the good old days,” O’Hara said “Nobody wanders into the market and says `I need 25,000 shares’ any more. You get massacred.”

Much of the damage is done by computers that have been loaded with dumb algorithms that are easily identified by HF programs designed to identify predictable patterns in the market. The chart below shows the price pattern for Coca-ColaCoca-Cola, one of the most liquid stocks on any exchange, on July 19, 2012 as a dumb trading algorithm went to work. Similar patterns were seen in IBMIBM, McDonald’s and Apple on the same day, and O’Hara said investigations showed India’s “flash crash” on Oct. 5, 2012 was caused by a trader who put too many zeroes on his order.

Coke stock, July 19, 2012: Dumb computer at work.

Low frequency traders complain that high frequency traders are front-running them or picking them off, but that’s just because they aren’t taking into account the new world of computer-driven trading, O’Hara told me. HF computers are exquisitely tuned to sniff out patterns that indicate human intentions, and the tipoff can be as simple as orders for lots of 100 or 1,000 shares.

“Computers don’t think in round numbers,” she said. “So whenever you see round numbers you can assume a human is involved.”

Similarly, HF computers look for evidence a trading algorithm isn’t tuned for the reality of the ebbs and flows in trading volume and bid-ask spreads. If such a computer sees a spike in the first minute of trading every half hour, she said, that’s a likely sign an institutional buyer is using a dumb algorithm to break a large order into pieces to be purchased throughout the day.

The HF-amplified jump in price is “only because the low frequency trader’s algo is stupid,” she said. “It shouldn’t be trading in the first minute of the first hour. It should be randomizing throughout the day.”

Institutional traders need to break their orders up into pieces that are invisible to the HF computers and spread them across a variety of platforms (some of them offered by O’Hara’s employer ITG) such as dark pools and crossing networks, where buyers and sellers are matched at the midpoint of the bid-ask spread.

Many institutions have figured this out, making the Lewis-fueled allegations in the Robbins Geller class action look dated. There are abuses, O’Hara said, but most of them are illegal. Some high frequency traders join in packs to push a stock down and discover where the stop-loss orders are; when those trigger a cascade of selling, they buy the stock back and ride it up. “Quote danglers” flash bids and take them away thousands of times a minute to try and convince a rival computer to raise its bid on apparent volume. If the sucker computer takes the bait, the quote dangler sells at a profit.

“There is good high frequency trading and bad high frequency trading,” said O’Hara, a trustee on the board of TIAA-CREF and member of the Commodity Futures Trading Commission’s “Flash Crash” committee. “Where it crosses the line is where you are trying to elicit behavior using trades that are manipulations.”

The bottom line is low frequency traders who buy and sell in large amounts and hold for more than a microsecond have to recognize that markets work differently now. The complaints of some traders that they are being outsmarted by other traders shouldn’t be allowed to override the benefits of higher liquidity, faster pricing and narrower spreads.

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I suppose I would believe myself to be smarter if my racks were all positioned to give me a distinct time advantage over other traders. Of course I’d be delusional but all that free money would push me to ignore that reality.

Ever since the Rothschilds used carrier pigeons to learn of Napolean’s defeat at Waterloo, somebody’s been faster. The question is whether you are getting an accurate, timely price with plenty of liquidity.

So no one would have an issue with me routing all the Goldman Sachs, JP Morgan etc connections through my router network analyzing what they are doing and profit from that? I mean certainly I’d be getting an accurate timely price with plenty of liquidity. No different from the Rothschild’s carrier pigeons right?

So do you think it’s ok for stores to watch you in the store and change the digital prices up when you look at items in that aisle? How about for lunch, would it be okay with you for fast food to go up when the line got long? This is the most ridiculous article trying to justify market rigging. And you even admit that some of it is illegal. How do you plan to stop the illegal activity?

Stores still have to sell at the marked price, last time I checked. But you live in a world of demand-driven pricing right now. Ever buy a walkup fare on an airline? Recruit a passenger so you can drive in the HOV lane? Pay a scalper extra for good seats at the concert? Ridiculous, I know, but that’s the way markets work.

I agree with concept of he who has the smartest algo’s and fastest computer can win. The real issue that no body is talking about is how purpose of wall street and investing has morphed into something completely different than it was intended to be. Not saying that is bad, but the low frequency people frustrated because they don’t know how to compete with it.

Stocks were meant to be bought on the prinicple of some future gain based on a good business operation. These algo’s don’t care what they’re trading and definitely aren’t looking future (more than a day) gain they’re trading on, it’s all about what news hits when and what trading patterns are happening for instaneous gains. To me, that is not true value creation, but who am I. Then the next question is, what is value creation and to whom? I think this is why you see the rise of altnerative investment sites like kickstarter popping up and thriving. People see value as different things.

HF trading has really put a bad taste in the mouth of investors who prefer the old style of trading. It’s hard to blame them if they want to put their money elsewhere, especially if you don’t have billion dollars laying around to have your own private fiber network from NYC to Chicago to trade that millisecond faster than the other guy. It’s innovation at work, but perhaps with a long term cost as the bots driving market conditions are only in it for a short term gain.

The HF traders are mostly irrelevant to buy-and-hold investors (unless they break the law to discover your stop-losses on illiquid stocks or engage in other shenanigans). You get your stock at a better price as a result of their constant trading. The institutional traders who manage the mutual fund in your 401(k) are a different story. They have to figure out how to avoid being front-run by computers that figure out what they’re up to while they’re doing it.

I don’t see how it is irrelevant at all to buy-and-hold investors. HF traders don’t care if the market goes up or down, they’re setup to profit as long as the market is moving enough one way or the other. The buy-n-hold guys believe the market will always go up based on efficient market theories, unfortunately not reality. So it’s a difference in what they beleive the market is for. The Lewis’s book just lifted the hood on what the market has morphed into and some feel helpless. It’s innovation in trading, which is good, but my point before was to prevote thought as to at what cost? While it maybe illegal or not I have no idea, if enough bots start seeing trading for a specific company, they feed off each other and feasibilly drive the price down to zero. It wouldn’t even have to be colusive behavior just smart algo’s doing what they do best. The company’s stock who’s sitting at zero did nothing to warrent that beating on their valuation. While the buy-n-holder loses a significant position for no reason other than the bots were doing what they do best. You have to admit, as a buy and holder or average joe investor, it is easy lose confidence in ability to get a return, long term or short term. The logic and facts doesn’t support having confidence in the market in it’s current state. If you want a return, you need a better algo and machine. Most people can’t do that nor would like to give blind control to their future. It’s an exciting time if you can stomach it.